Delaware Continues to Focus on Valuation Issues: In re El Paso S'holder Litig.
Kevin Miller of Alston & Bird provides this analysis: Although the primary focus of the press coverage regarding the recent In re El Paso S'holder Litig. case in the Delaware Court of Chancery has been on alleged management and financial advisor conflicts, there is a lot of discussion in the hearing transcript regarding valuation issues:
1. Chancellor Strine specifically references the debate as to whether terminal value multiples should be based on a comparable companies analysis (which may implicitly include a minority discount) or a comparable transactions analysis.
2. Plaintiffs allege that the terminal multiples used by El Paso's financial advisors implied a perpetuity growth rate of 0.7% for a a company that allegedly has significant growth prospects - arguing that its absurd for the financial advisors to have used financial analyses implying that El Paso will grow at less than half the rate of inflation.
3. Chancellor Strine appears critical of using a terminal value multiple based on a comparable companies analysis that is below the mean/median multiple for the comparable companies - effectively taking a haircut off of a multiple that already reflects a minority discount.
See the following quotes from the attached transcript:
On Selection of Terminal Value Multiples
THE COURT: I understand. I assume you'll think it's too low. There are ways to do exit multiples because there is, for example, a philosophical debate you could have about if you use a current trading multiple of comparable companies, does that arguably embed a minority discount if you use this as an exit multiple.
On the other hand, if you think the growth rate of companies over time tends to normalize to the market perhaps using the current trading multiples, adjust for that. And, whereas, if you use comparable transactions, which are sales of whole companies, then you'd be overstating the future exit multiple.
You know, so there is that philosophical debate that men and women of valuation science and the academy never solved these problems.
And they don't really think about them much, but judges like us who have to do appraisals do.
What did they, in fact, use? Did they use a current sample of so-called comparable companies? Did they use comparable transactions? [...]
MR. DiPRIMA: I think it's trading data. And they did look at a median for the current period and used a slightly lower multiple for the terminal period. And that's calculated in the book, Morgan Stanley's --
THE COURT: So they used a lower period for the -- they used a minority, a current minority trading multiple, and then they reduced it to use it as an exit multiple for an entire company?
MR. DiPRIMA: The multiple they used is I believe slightly below the median.
THE COURT: Of the current minority trading multiples?
MR. DiPRIMA: Correct. And I think part of the idea of that is that when you're out to 2016, you're in a slower growth period.
THE COURT: Well, if that's the idea of it, and that may be part of why I talked about before decelerating the multiple by using a current minority trading multiple, but what you're saying is they decelerated it even more. They took the minority --
On The Implied Perpetuity Growth Rate
THE COURT: I think what Mr. Clarke said, fundamentally, about KMI is if you look at the objective economic information in this record about KMI versus El Paso in the pipeline area, a big reason why KMI was buying El Paso was because of the attractiveness of its pipeline business; that if, really, what you're assuming is that the future prospects of that pipeline business as recently as 2015 will translate into a perpetuity growth number of about a third of the historical inflation rate, then Kinder Morgan would not be doing this deal. The whole premise of the deal is stupid. That El Paso is dead. And yeah, I mean, this would be a great deal $10 per share less or something like this.
I mean, to get to a perpetuity growth rate of .7 takes some doing because what you have, obviously, is you're going to have growth. You look at periods. And there might be a period between 2015 to 2025 where El Paso is still growing higher than the market.
Then you're talking normalizing. Usually, you have to normalize through when they grow at the rate of the overall economy, then to where they kind of keep and they're sort of the same share. This assumes that they're relatively rapidly becoming less valuable as a proportion of the economy; in fact, not keeping up with inflation; in fact, not even keeping up with half of inflation; and it's just a really odd thing.
On the Use of Medians
THE COURT: I'm talking about whether they used the median -- look, I'm not saying the bankers did it here, but it is often the case that bankers will come up with eight comparable companies. That will generate a median. And use something that turns out to be the multiple of one of the companies, and they don't use the median of their selected companies.
On Equity Risk Premium
THE COURT: Having had a case, frankly, where a very large bank changed the historical -- the way it made a deal look more fair was to have its view of the historical equity risk premium change by nearly 2 percent within a period of two months. Which is a remarkable intellectual achievement, given that the historical risk premium is calculated -- there is a debate about whether it goes back to the Ibbotson data or whether it goes back to the 19th century.
And then when I asked them whether they had done it at their committee, this is something they had decided for all representations, no. They were on the buy side. I said, Would you ever use this on the sell side? And the guy actually was real candid, and said something like, Heavens no. You know, and --